Budget big picture: Context of historic tax cut, what impact it may have on the economy

The Union Budget 2025-26 has been presented at a time when India’s economic situation faces some formidable challenges.

Notwithstanding the structural reforms carried out over the past few years — such as the introduction of Goods and Services Tax (intended to simplify the indirect tax regime), several ease-of-doing-business measures (such as the Insolvency and Bankruptcy Code), and a historic tax cut for companies in 2019 — the Indian economy has lost momentum over the past few years.

The biggest representation of this loss of momentum has been a slowdown in personal consumption by the average Indian. That, in turn, has been a representation of the tepid job creation in the economy.

Most new jobs that are being created are in the shape of women joining the workforce in self-employed categories of work that barely provide subsistence-level incomes. The Economic Survey showed that real wages for self-employed persons are still below 2017-18 levels.

Low and stagnant incomes and the poor quality of job-creation has been made worse by rising levels of indebtedness. According to the Reserve Bank of India, household debt rose to 41% of GDP in FY24 from 37.9% in FY23 — an all-time high. This debt refers to loans such as personal loans, agriculture loans, home loans, etc.

The poor job creation was a consequence of the government’s policy focus that concentrated too closely on capital-intensive production, with very little attention paid to employment generation. For instance, labour intensive sectors such as textiles and leather industries or MSMEs continued to suffer while the government heavily subsidised big companies through Production-linked incentive (PLI) schemes.

The broader economic philosophy of the government since 2014, and more so since 2019, has been to give up stake in the economy, and allow the private sector to take the lead in job-creation and economic output generation.

For its part, the government concentrated on providing more and more physical infrastructure, even as it attempted to give up control of public sector units via the disinvestment process.

Poor outcome of govt efforts

At one level, this strategy makes sense. However, the consumption-led slowdown that was taking a stranglehold on the economy even before Covid-19 struck, was made worse by the pandemic and the loss of jobs that it caused.

Households ate into their savings to survive, even as job creation trailed the overall GDP growth recovery. This also led to a sharp increase in inequality. The number of people employed in India’s manufacturing sector halved — coming down from 51 million to 27 million between 2016 and 2020. At the same time, India started witnessing a reverse movement of people from industry to agriculture.

In 2019, the year before the pandemic hit, India’s GDP grew by less than 4%. The government reacted by cutting corporate tax, the tax that companies pay on their income. The hope was that this cut would incentivise companies to make new investments with the extra money in their hands, thus creating new jobs and prosperity. To “crowd in” such investments, the government also ramped up its capital expenditure to historically high levels.

But despite the government’s increased spending on building productive assets such as roads and ports, as well as the massive corporate tax cut, the economy was not able to break free. India’s GDP has grown at an average of less than 5% annually since 2019, and less than 6% since 2014.

Finance Minister Nirmala Sitharaman as well as the rest of the government have been exasperated that the private sector did not play along with the overall government strategy for growth. Once, the FM even asked if the private sector in India is like Lord Hanuman, unaware of its own powers (to invest).

The government has been scratching its head about what to do to incentivise the private sector. Indeed, on paper, almost everything the government thought it should do has been done.

Attempt at course-correction

Many observers have pointed out that companies were unwilling to invest in fresh capacities until they could be sure there was enough demand in the economy for their products.

Saturday’s Budget announcement of a massive income tax break is an acceptance by the government that more than anything else, the private sector investments require robust consumer demand.

Almost everything else — corporate income tax and interest rates and the condition of roads — is secondary.

With discontent among its most loyal voters rising, the government has finally bit the bullet and announced an income tax cut as a way to spur consumer spending. In effect, this is an acceptance that the corporate tax cut of 2019 has not worked.

The fact is that the 2019 move was poorly timed — since it offered a supply-side solution to a demand-side problem. The hope now is that consumers will spend the additional money in hand — around Rs 1 lakh crore that the government is foregoing as revenues — and that this will provide corporates with the essential reason to invest in new capacities, create jobs, and further spur economic growth.

Tax-cut impact on economy

A tax cut will have a positive effect on the overall economy, said Prof N R Bhanumurthy, head of the Madras School of Economics and author of an academic paper on “multipliers” — or how government decisions affect the overall GDP.

The multiplier for a personal income tax cut is 1.01. That is, a Re-1 cut in personal income tax grows the GDP by Rs 1.01 as people spend the money.

“Of course, that multiplier is for normal periods. Given that the consumption cycle is down, it will perhaps have an even higher effect,” Bhanumurthy said.

It is quite possible though, that some of the money will not be spent. Even then, the move will have a positive impact. Here’s how:

More savings will allow the financial system to bring down the cost of new loans (that is, the interest rate). Lower interest rates will incentivise more loans and economic activity.

The question then is: Will this amount be enough to trigger the virtuous cycle of economic growth?

By itself an additional Rs 1 lakh crore, or a tad more, may not be enough. India’s GDP at the end of the current financial year would be Rs 324 lakh crore, while the total private final consumption expenditure (or the aggregate money spent by Indians in their personal capacity) is Rs 200 lakh crore. As such, the increment of Rs 1 lakh crore would by itself be a fairly small change in the larger scheme of things.

Nikhil Gupta, chief economist at Motilal Oswal, said people are likely to have an opinion about this based on whether they are feeling optimistic or pessimistic.

“For instance, compare this amount with all the welfare measures (cash transfers) announced by state governments in the past one year. Reportedly, it ranges between Rs 3 lakh crore and Rs 4 lakh crore. So if until yesterday, that amount could not lead to a virtuous cycle, it is an open question how much this additional amount will achieve. That being said, there is no doubt that on the margin this move will help matters,” Gupta said.

It is for this reason that Gupta believes that listed companies will do well — as will the stocks of companies that sell consumption goods.

“But if you say that (positive movement in stocks) will continue for the next one month, forget about the next one year, I have my doubts,” Gupta said.

Bhanumurthy added another caveat. To the extent the money is spent, it will spur demand and to the extent that demand can be serviced by the domestic economy, all will be fine, he said.

However, if the expenditure is on goods and services that cannot be provided by domestic producers, then the additional demand can also show up as higher imports or higher domestic inflation (more money chasing the same number of goods).

Key element still lacking

However, there is a crucial element still lacking in the Budget: a comprehensive strategy for economic growth without which tax cuts will not be enough.

Gupta said that for him the biggest problem was the lack of income growth in the country. Tax cuts can provide an initial fillip — a cut in GST would have been better — but they cannot on their own sustain consumption if economic growth doesn’t happen.

One reason why the effect of this tax cut — historic in itself — is likely to be limited is that the total number of people paying income tax itself is very small in relation to the size of India’s population.

Arguably, if the government’s policy intervention sequencing was reversed — income tax cut first and corporate tax cut later — the results could have been different.